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Preference Shares in Private Limited Companies – A Comprehensive Guide

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Last Updated on April 20, 2023 by Kanakkupillai

We cover “A Complete Guide to Preference Shares in Private Limited Companies” in this blog post for the benefit of interested readers.

Definition of Preference Shares

Preference shares allow investors to hold stock in the issuing firm with the proviso that holders of the shares will receive dividend payments first whenever the company decides to do so.

Overview of their Role in Private Limited Companies

Preference shares are also known as preferred stock. These are stock shares that a corporation owns, whose dividends are paid to owners in advance of the issuance of common stocks. Preferred shareholders are entitled to receive payment from corporate assets before common shareholders if the private company files for bankruptcy.

Unlike regular stocks, the majority of preferred shares receive a fixed dividend. Common shareholders typically have the opportunity to vote, but preferred shareholders typically do not. Convertible preferred stock, cumulative preferred stock, non-cumulative preferred stock, and participatory preferred stock are the four categories under which preference shares fall.

Non-cumulative preferred stock does not pay out any dividends that are late or missing. Non-cumulative preferred stockholders have no right or authority to recover any foregone dividends in the future at any time if a firm chooses not to pay dividends in any particular year.

The right to receive dividends equal to the generally accepted rate of the chosen dividends, plus an additional payout based on a specified condition, is granted to the owners of participating preferred shares.

With convertible preferred shares, shareholders have the opportunity to exchange their preferred shares for a predetermined number of common shares at any time after a set date. Thus, convertible preferred shares are typically exchanged at the owner’s request.

Corporate shares, known as preference shares (preferred shares), pay dividends to stockholders before common share payments are distributed. There are four different kinds of preferred stock: convertible, participating, and cumulative (guaranteed) shares.

Preferential shares are appropriate for risk-averse investors and are callable (the issuer can redeem them at any time).

Key Takeaways

  • Preference shares allow investors to hold stock in the issuing firm with the proviso that holders of the shares will receive dividend payments first whenever the company decides to do so.
  • Advantages of Preference Shares
  • Preference shares can be used to increase the marketability of equity shares and debentures by increasing their value on the open market.
  • Disadvantages of Preference Shares
  • Verify if the company’s articles of association allow the issuance of preference shares.

Types of Preference Shares

The numerous types of preference shares include the following:

  • Convertible preference shares
  • Non-convertible preference shares
  • Redeemable preference shares
  • Non-redeemable preference shares
  • Participating preference shares
  • Non-participating preference shares
  • Cumulative preference shares
  • Non-cumulative preference shares

1) Cumulative preference shares

Shareholders who own cumulative preference shares have the right to receive cumulative dividend payments from the business, even if it is not profitable. In years when the corporation is not profitable, these dividends will be considered past due.

2) Non-cumulative preference shares

Non-cumulative preference shares pay a fixed annual dividend to the shareholder from the business’s net earnings. However, the shareholder will not be able to claim the dividend on such preference shares in the future if the corporation fails to pay it to them in any given year.

3) Participating preference shares

A participating preference share is a share that entails the possibility of a profit share in place of or in addition to a predetermined dividend. In general, the profit share, also known as a participating dividend, is defined as a right to a specific portion of the company’s profits.

4) Non-participating preference shares

Non-participating preference shareholders, as the name implies, do not receive a portion of any surplus assets or earnings following a company’s dissolution. Just the prefixed dividends are available to shareholders of this sort of share.

5) Redeemable preference shares

A redeemable preference share is a share that can be redeemed by the issuing firm or the holder (i.e., exchanged, most likely for cash). Alongside a company’s ordinary share capital, redeemable preference shares make up a separate class of share capital.

6) Irredeemable preference shares

A corporation can only redeem irredeemable preference shares upon liquidation or ceasing operations. Indian businesses are nonetheless unable to issue irredeemable preference shares.

7) Convertible preference shares

A type of preferred share known as convertible preferred stock allows the holder to convert them into a certain number of common stock shares.

8) Non-convertible preference shares

Non-tradable preference shares cannot be changed into the company’s regular equity shares. Yet, in the event of the company’s dissolution, they continue to hold preferred rights to the payment of capital over common shareholders.

Different Types of Preference Shares

Advantages of Preference Shares

Preference shares have the following benefits:

  1. Suitable to cautious investors: This is appropriate for investors who prefer fixed dividends and do not enjoy taking on risks.
  2. Retention of control: By issuing preference shares, the existing owners can keep control of the company because those shareholders can only vote on issues that directly impact them. There won’t be any loss of control as a result.
  3. Attractive types: It is more desirable to own redeemable, convertible, and participatory preference shares. They have a ready market since they are very useful to investors.
  4. Convenience: Debentures typically result in the creation of a charge or mortgage on the assets. Yet, no such creation is necessary for the issue of preference shares.
  5. Gain in income for equity shareholders: By issuing preference shares, equity stockholders gain a sizable dividend.
  6. Conversion to satisfy legal requirements: Preference shares may be issued to liquidate public deposits of corporations that exceed the Reserve Bank’s maximum limit.
  7. Economical: Financing preference shares is less expensive than financing equity shares. They can thus be granted to cover significant capital expenses.
  8. Facilitating reconstruction and reorganization: If a firm is reorganized or rebuilt, the board can simply convert the debts into preferred shares with the approval of the creditors.
  9. Increasing the marketability: Preference shares can be used to increase the marketability of equity shares and debentures by increasing their value on the open market. A bonus of a particular number of preference shares may be given to everyone who purchases a certain number of equity shares.
  10. Excellent debenture alternative: Preference shares may be issued in place of debentures by companies with average annual returns but unstable income that cannot cover regular debenture interest.

Disadvantages of Preference Shares

The main drawbacks of preference shares are as follows:

  1. Heavy dividend: Preference shares often have a greater dividend rate than debenture interest rates.
  2. Absence of voting rights: Due to the lack of voting rights, equity shareholders may harm the interests of preference shareholders.
  3. Method of liquidation: Occasionally, the board may distribute dividends to the preferred shareholders in place of employing the limited cash resources for productive purposes. In the end, this can lead to bankruptcy.
  4. Financial status: The presence of preference shares may have an impact on the company’s creditworthiness.
  5. No income tax exemption: The corporation must earn more because preferred dividends are not deductible for income tax purposes. The dividend paid to equity stockholders will be impacted otherwise.

How to Issue Preference Shares?

Only redeemable preference shares may be issued by an organization. Also, a corporation must issue shares with a 20-year redemption period. When preference shares are redeemed, the shareholders will receive their money at a specific time or on a specific date.

Authorization and Issuance Procedures

Key aspects

  • Confirm that the business is limited by shares.
  • Verify if the company’s articles of association allow the issuance of preference shares.
  • Within 20 years after the issuance date, preference shares must be redeemed. Only businesses engaged in infrastructure projects are permitted to offer preference shares with a 20-year redemption period.

Step 1: Call the board meeting

Call a board meeting by providing each firm director with at least seven days’ notice. Set the date, time, location, and agenda for the general meeting that will be called to pass the special resolution authorizing the issuance of preference shares.

Step 2: Draft a board resolution

Publish a board resolution authorizing the issuance of preference shares.

Step 3: Draft an explanatory statement to the board resolution

Explain the board resolution that includes all the relevant information about the proposed issuance of preference shares. The explanatory statement must contain details like:

  • Dimensions, the number of preferred shares to be issued, and the price per share.
  • The types of shares that will be issued, such as convertible or non-convertible, participating or non-participating, cumulative or non-cumulative, etc.
  • Goals of the issue.
  • Shares’ issuance procedure.
  • The distribution price for the shares.
  • The terms of the issue, such as the conditions and the dividend rate (coupon rate) on each share.
  • The terms of redemption, such as the length of the redemption period, the redemption of shares at a premium, and, if appropriate, the terms of conversion.
  • Manner and modes of redemption.
  • The company’s current shareholder structure.
  • The anticipated equity dilution upon conversion, if relevant.

Step 4: File MGT-14

Within 30 days, submit the special resolution that was authorized at the board meeting to the ROC using Form MGT-14. A copy of the approved special resolution as well as the justification must be included in MGT-14. A managing director, director, or secretary of the firm designated by the board must digitally sign the document. A chartered accountant, cost accountant, or company secretary in full-time practice must additionally digitally sign and certify the document.

Redemption and Conversion of Preference Shares

Irredeemable preference share issues are prohibited by the Companies Act of 2013. According to the Act, a corporation limited by shares may issue preference shares that are subject to redemption within 20 years of the date of issuance. However, a company engaged in creating and managing “infrastructure projects” may issue preference shares for a duration exceeding 20 years but not exceeding 30 years, subject to the redemption of at least 10% of such preference shares each year beginning in year 21 or earlier, on a pro-rata basis, at the discretion of the preference shareholders.

Further, the Act provides that

  1. No such shares may be redeemed other than using company profits that would otherwise be available for dividends or the proceeds of a new share issuance made specifically for such redemption;
  2. These shares cannot be redeemed unless they are paid in full;
  3. For businesses other than non-banking financial companies (NBFCs), the premium, if any, payable upon redemption shall be paid out of the firm’s profits or out of the securities premium account of the company before the redemption of such shares;
  4. If the company decides to redeem any of these shares using its earnings, the firm must transfer a sum equivalent to the nominal value of the shares to be redeemed to a reserve account that will be known as the “capital redemption reserve account” out of those profits.

Taxation of Preference Shares

Additionally, investing in preference shares should be considered an investment in unlisted and unquoted security, making it unquestionably tax deductible. Only in the case of investments from which the income is exempt from tax does Section 14A apply.

Tax Treatment for the Company

Why there isn’t a direct tax benefit

The issuing corporation does not receive a direct tax benefit from issuing preferred shares. This is because fixed cash dividends that are paid out after taxes are due on preferred shares, which are a type of equity capital. The same applies to common shares. Dividend payments are usually made with after-tax money, so there is no current tax deduction available.

Preferred shares are compared to debt since they have a fixed rate of return, just like bonds (a debt investment). Preferred shares are viewed as a more expensive form of financing because interest payments on bonds are tax deductible, whereas preferred shares are paid with after-tax money.

Preference Shares versus Ordinary Shares

There are several distinctions between preference and common shares, which are covered in the table below:

Preference Shares

Ordinary Shares

Definition

Preference shares are a type of financial instrument that businesses use to raise cash and offer shareholders the chance to receive dividends. Ordinary shares are another financial tool that businesses utilize to generate capital and give shareholders voting rights.

Rate of dividend

A set dividend rate applies to preference shares. For common shares, there is no set dividend rate.

Voting rights

Shareholders with a preference do not have any voting rights for major corporate decisions. Regular shareholders can vote on important corporate decisions.

Bonus shares

No bonus shares may be issued by the corporation to preferred shareholders. Bonus shares from the corporation are available to regular shareholders.

Role in management

Preference shareholders are not involved in the organization’s administration. Ordinary shareholders are involved in the organization’s management.

Arrears

There is a demand for dividend arrears from preference owners. Ordinary shareholders are not entitled to any compensation for dividend arrears.

Types of shares

The following list includes the many types of preference shares:

  • Cumulative preference share
  • Participating preference share
  • Redeemable preference share
  • Convertible preference share
  • Non-cumulative preference share
  • Non-participating preference share
  • Non-redeemable preference share
  • Non-convertible preference share
The following list includes several categories of ordinary shares:

  • Authorized share capital
  • Issued share capital
  • Subscribed share capital
  • Paid-up share capital
  • Right share
  • Bonus share
  • Sweat equity share

Conclusion

For the benefit of interested readers, we are now providing a summary of the main ideas discussed in this blog.

Often referred to as “preferred stocks,” preference shares are those that allow stockholders to receive dividends declared by the company before receiving them from equity shareholders.

Redeemable preference shares are a form of preference share that must be redeemed in India within 20 years of the date of issuance.

Businesses in India are not permitted to issue irredeemable preference shares, according to the Companies Act of 2013.

The key characteristics of preference shares are as follows:

  • They are transformable into common stockIt is simple to convert preference shares into ordinary stock. A shareholder’s shares are changed into a set number of preference stocks if they wish to modify their holding position.
  • Payouts for dividendsWith preference shares, shareholders can receive dividend payments when other stockholders would not or might receive dividends later.
  • Preference for dividendsAs opposed to equity and other shareholders, preference shareholders have the significant advantage of getting dividends first.
  • Voting rightsIn the event of extraordinary occurrences, preference shareholders are entitled to the opportunity to vote. Unfortunately, this only occasionally occurs. Normally, buying shares in a firm does not grant you voting privileges in the management of the company.
  • Asset preferencePreference shareholders are given precedence over non-preference shareholders when discussing a company’s assets in the event of liquidation.

The Future Prospects for Preference Shares in Private Limited Company

Without a shadow of a doubt, the prospects for preference shares in a private limited company are favorable, as justified below:

  • Preference shares are those shares that have a preferential right to a capital return upon the business’s dissolution as well as dividend payments at a fixed rate for the duration of the firm. They are given preference over stock options.
  • Preference shareholders do not have the same voting rights as common shareholders, which is the fundamental drawback of owning these securities. Having a fallback strategy is wise in case something goes wrong.
  • The price of preferred stocks increases when interest rates are low and decreases when they are high. As interest rates decline, the yield provided by a preferred stock’s dividend payments becomes more alluring, increasing investor demand and driving up the stock’s market value.
  • Some preference shares are qualified to receive any accumulated dividend arrears. Preference shares have lower risk than equity shares, making them suitable for medium- to long-term investments.
  • When it comes to dividend payments, preference is given to shareholders over equity owners. Preference shares are less hazardous to invest in than equity since preference shareholders get priority over equity owners in the event of a firm’s insolvency.
  • Yet, preferred shares are typically regarded as a secure investment because they are typically issued by businesses in the banking and financial industry, which are less likely to default than other businesses.

Additionally, investing in preference shares should be considered an investment in unlisted and unquoted security, making it unquestionably tax deductible. Only in the case of investments from which the income is exempt from tax does Section 14A apply.

Final thoughts

A respectable standing among Shareholders of a Company can be attained through the acquisition of preference shares. The main benefits of receiving dividend payments go to preference shareholders if the corporation perceives stock liquidity.

Based on our conversation thus far, we anticipate that this blog will be interesting to all readers who are interested in learning about the fundamental ideas and characteristics of preference shares.

At Kanakkupillai, we specialize in providing comprehensive services for private limited company registration, including assistance with issuing preference shares. Contact us today to learn more about how we can help you raise capital and grow your business.

Kanakkupillai

Kanakkupillai is your reliable partner for every step of your business journey in India. We offer reasonable and expert assistance to ensure legal compliance, covering business registration, tax compliance, accounting and bookkeeping, and intellectual property protection. Let us help you navigate the complex legal and regulatory requirements so you can focus on growing your business. Contact us today to learn more.